Bond Bubble to Burst?

Here are a few defensive strategies to protect against an end to the runup in fixed income over the past few years.

Juliette Fairley | Apr 01, 2012

For the past two years, Mark Blinderman, who works as an IAR for a registered investment advisory in Brooklyn, N.Y., has been shifting away from municipal bonds and Treasuries towards dividend-paying equities and inflation-protective bonds (TIPS). He believes we are in the midst of a bond bubble that will inevitably burst.

Investors have poured money into bond funds since the crash. In 2009, $284.5 billion in net new assets flowed into taxable bond funds, compared to outflows of $25.7 billion for U.S. stock funds, Morningstar says. Basically, investors have been selling domestic equity funds for five years.

Previously, Blinderman's average portfolio was 50 percent invested in fixed income and 50 percent in equities. Today, his average portfolio is 60 percent equities and 40 percent fixed income. “Bonds have interest-rate risk working against them. As a result, our mix of bonds has changed. We're investing more in short-term corporate and high-yield as well as inflation-protected securities, such as TIPS,” says Blinderman who manages a little under $30 million.

In addition to the billions that flowed into bonds, the Federal Reserve plans to keep short-term interest rates near zero until 2014. Critics are concerned about the risk of inflation and even see it as a warning.

“We are looking at a bond bubble. We've seen a 30-year secular bull starting with 16-percent rates in 1981, then declining gradually, and now less than 2 percent on the 10-year U.S. Treasury,” says Ryan Leib, an accredited investment fiduciary and CFP with Keystone Wealth Management in Conshohocken, Pa. “Interest-rate risk is the most important yet least talked-about risk, and it's the baby boomers who are going to get slammed.”

As a result, Leib's investing has changed. These days he's investing in step-up bonds and floating rate funds because they reduce interest rate risk and are less risky than fixed interest rate bond products.

“I've been getting out of typical corporate bond funds, government bond funds, municipal bonds and traditional bond funds that have fixed interest because they will be going down when the interest rate goes up in 2014, if not sooner,” says Leib.

Today's 10-year Treasury is currently yielding 2.016 percent, according to QUODD data.

When interest rates had initially fallen in June 2011, indicators suggested U.S. government debt had become overvalued. That's when RIA Patrick Hejlik underweighted his clients' blended portfolios in sovereign debt by 15 percent. Prior to June 2011, Hejlik's portfolios had been equally weighted in equities and fixed income.

“We moved our clients' assets out of U.S. Treasuries and European sovereign debt and into option strategies that revolve around municipals, corporate and high-yield bonds,” says Hejlik. “The unique strategy that differentiates us from the competition is our expertise in option strategies.”

Option strategies built around equities is another tactic employed by investors seeking a safe haven from the fear that a bond bubble will burst.

Mike Scanlin exepects to earn a 10 percent return a year without much risk with covered call options. Investors who sign up for his software don't completely abandon their bond investments but rather shift a portion of their bond investments into covered calls to get a higher blended yield.

“In addition to the call premium, if you're trying to live off your bond income, it's a better deal,” says Scanlin, CEO and founder of the website BorntoSell.com. “Covered call options are more defensive than buying equities outright and less defensive than holding bonds to maturity, which would be the most conservative.”

If 10-year interest rates, which are now 2.8 percent, rise to 4 percent as they did last spring, bondholders will suffer a capital loss more than three times the current yield.

Advisor David K. Sherman of Cohanzick Management in Pleasantville, N.Y. says he wouldn't touch Treasuries today because there's no compensation for rising interest rate risk and credit risk. Instead, he's investing in the short part of the curve with junk bonds that have an effective maturity of three years or less, out of concern that rates are way too low.

“We buy debt that has been called, redeemed and funded at 3 to 4 percent and hold for 30 days. These are bonds that have been called by the parent company. They are being refinanced and the funding commitment has been reached,” says Sherman, who manages $325 million. “The risk we take is that the company can't get out of the obligation unless they go bankrupt. We don't think they're going bankrupt.”

Earning on a gross basis between 3.5 and 5.5 percent, the weighted average maturity of Sherman's portfolio is four to eight months with 40 to 60 percent of the portfolio rolling into cash every 90 days.

“Twenty percent of our portfolio has a maturity of one to three years and the remaining will mature greater than 90 days but less than one year,” he said.

Hatteras Funds CEO Bob Worthington isn't shying away from investing in bonds. Instead, his strategy is to diversify and hedge.

“If the fixed income portion of your portfolio goes down, you will lose less by employing hedged strategies because short positions and hedges tend to perform best as bond prices decline,” says Worthington who likes corporate B, double B and lower single A bonds because the spread is reasonable, at 600 bps over the curve.

A hedge can be created with stocks, exchange traded funds, insurance, forward contracts, swaps, options and many types of over-the-counter, derivative and futures contracts.

“If you short securities and they go down in price, you make money. It's a way to protect capital when an asset class goes down in value. We are mitigating volatility in a bond bubble with a hedge strategy,” says Worthington.